Replacement cost refers to the price that it would cost to replace an existing asset with a similar asset at the current market price. The asset in question can be a real estate property, investment security, or account receivable.
For example, if a building suffers from damage caused by a fire or terrorist activity, the replacement cost of the asset would refer to the pre-damaged condition of the asset. The actual replacement cost is subject to change because a new asset would incur different costs than the original asset. However, the replacement cost does not require to be a duplicate of the original asset, and it must serve the same purpose as the original asset.
The replacement cost is the cost that an individual or entity would incur to replace an asset with a similar asset at the current market prices.
For a damaged asset, the replacement cost for that asset takes into consideration the pre-damaged condition of the asset.
Replacement costs are common in homeowner insurance policies to cover assets that are damaged or destroyed in a disaster, such as an earthquake, flood, or fire.
How to Determine the Replacement Cost of a Building?
The process of determining an appropriate cost estimate of replacing a building is complex, and it requires various pieces of data and knowledge of construction in order to make an informed estimate. When making a decision on the building to be replaced and the cost to be incurred, businesses use the net present value (NPV). The NPV method is used to analyze the cash inflows and outflows in order to make a purchase decision. It uses a discount rate to estimate the minimum rate of return on the asset.
Before making a purchase decision, the company must analyze both the cash outflows of the asset, as well as the inflows generated by the asset. The cash flows are adjusted to their present values using the discount rate to make them current. The difference between the present value of cash inflows and outflows informs the final decision.
If the difference is positive, it means that the asset is profitable, and the company can proceed with the purchase. However, if the difference is negative, it means that the value of outflows exceeds the inflows, and the company should not go ahead with the purchase.
Accounting for Depreciation
When determining the replacement cost of an asset, a business must account for its depreciation to expense its cost over its useful life. To capitalize on an asset purchase, the cost of the new asset is posted to an asset account, and the account depreciated over the useful life of the asset.
Depreciation matches the expense of using the asset during its useful life and the revenue it generated. Businesses can use the straight line depreciation method or the accelerated depreciation method. The straight-line depreciation method divides the cost of the asset over its useful life to get the annual depreciation cost, while the accelerated depreciation method recognizes more depreciation costs in the early years and less in the later years.
Market Value vs. Replacement Cost
Market value and replacement cost are both distinct concepts that are used to estimate the value of a property. The market value is the price that a property will fetch in the open market between two parties, i.e., the buyer and the seller, who are both knowledgeable about the dynamics of the real estate market.
When estimating the market value of a property, parties include the value of the land and the value of site improvements to the land, less the accrued depreciation. A property’s market value is affected by several factors, such as location, crime rate, proximity to social amenities, etc.
On the other hand, replacement cost includes the estimated cost of constructing a building that is similar to the building being evaluated at the current prices. The method considers the prices of materials, labor, and special fees at the time of the valuation.
The replacement of the building uses current building designs and standards, as well as modern methods, which may differ from the cost of the building being appraised. It excludes other costs, such as demolition, debris removal, premiums for materials, site accessibility, etc.
Replacement Cost in Insurance Policies
Replacement cost is included as part of a homeowner’s insurance policy to cover the damage caused to a policyholder’s assets. The policyholders must make sure that the definition of the asset insured is clear. It is because the insurance company commits to pay the policyholder the replacement cost of covered assets if they are destroyed, stolen, or damaged.
Most insurance policies include a clause in the insurance policy that states that the lost asset(s) must be replaced or repaired before they can pay the replacement cost. Insurers do it to avoid over-insurance, where an insured party engages in a moral hazard, such as arson, to make a false claim and profit from the loss.
Due to the constant fluctuation of the cost of labor and materials, insured parties should regularly review their homeowner’s policy to ensure that the replacement cost is enough to cover them from loss, should a disaster occur.
If a policyholder is underinsured, i.e., the insurance coverage is insufficient to cover the replacement cost of the assets damaged in a qualified disaster, they may be required to incur huge out-of-pocket costs for the uninsured assets.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:
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